Understanding Variable Annuities: Features, Risks, and Legal Considerations

Variable annuities are unique financial products that blend insurance and investment elements. They offer a combination of market-based growth potential and retirement income. These products are often utilized as a component of retirement planning, appealing to those seeking market returns while securing an income stream in later years. However, variable annuities are also costly and complex and come with certain risks that investors must carefully evaluate.

A variable annuity is essentially a contract between an investor and an insurance company. The investor makes one or more payments, and the insurer invests the funds in underlying securities, typically mutual funds, within the annuity. Unlike fixed annuities, where payments are predetermined, the value of a variable annuity fluctuates based on the performance of these investments. The goal is to provide growth through market exposure and, eventually, steady income during retirement.

The structure of a variable annuity includes two primary phases: the accumulation phase and the distribution or annuitization phase. During the accumulation phase, the investor contributes funds, which are allocated to different investments, also called subaccounts. The performance of these investments determines the annuity’s value during this period. In the distribution phase, the investor begins to receive payouts, which can take the form of a lump sum, periodic payments, or guaranteed income for life. The amount and duration of these payments depend on the annuity’s value at the time of distribution and any guarantees or riders the investor has chosen.

Variable annuities offer several features that distinguish them from other financial products. One key advantage is tax-deferred growth, meaning that earnings within the annuity are not taxed until withdrawn. This can be a significant benefit for investors looking to maximize the growth of their retirement savings. Many variable annuities also provide death benefits, ensuring that a beneficiary receives a specified amount upon the policyholder’s death, regardless of market conditions. Investors can also enhance their contracts with optional riders, such as guarantees for minimum withdrawals or lifetime income, though these come at additional costs. The variety of sub-accounts or investment options provides flexibility, allowing investors to tailor their portfolios to match their risk tolerance and financial goals.

While variable annuities may appear appealing due to their features, they come with significant drawbacks, particularly when compared to simpler investment products such as mutual funds. One of the most notable disadvantages is the cost. Variable annuities are much more expensive than mutual funds due to their layered fees. These include mortality and expense risk charges, administrative fees, and investment management fees, which can all significantly erode returns.

In addition to these standard fees, optional riders such as lifetime income guarantees or enhanced death benefits add even more costs. Investors considering optional riders should carefully evaluate whether the benefits provided by these riders will vest within a reasonable timeframe. Many riders, such as guaranteed minimum income or step-up death benefits, come with specific conditions or waiting periods before they materialize. If the vesting period is too long relative to the investor’s financial goals or life expectancy, the added cost of the rider may outweigh its potential benefits. Therefore, it is crucial to align the annuity and rider terms with one’s personal financial timeline to ensure these features offer meaningful value.

By contrast, mutual funds typically charge only an annual expense ratio for fund management, which is generally much lower than the combined fees associated with variable annuities. For many investors, the excessive cost of variable annuities can substantially reduce the net returns they achieve over time, raising questions about whether the benefits justify the expense.

Another key distinction is liquidity. Investors who purchase variable annuities often face surrender charges if they need to access their funds early, which can last for six to eight years or more. These surrender charges add yet another layer of cost that is not present in mutual funds, where funds can generally be redeemed at their current value without penalty. This makes variable annuities less flexible and more restrictive for investors who may require access to their money in the short or medium term.

An important component of suitability analysis for variable annuities is the consideration of share classes. Variable annuities offer multiple share classes, each with its unique cost structure and implications for investors. Some shares have a front-end sales charge but lower ongoing expenses, making them more suitable for long-term investors who intend to hold the annuity for an extended period. Other shares do not require upfront charges but often come with higher ongoing expenses and longer surrender periods, making them less ideal for those who may need access to their funds in the short term. Yet other shares, offer a reduced surrender period compared to other share classes, usually around three to four years. While they may provide greater liquidity for investors who might need to access their funds sooner, they often carry higher ongoing expenses compared to other shares.

Financial professionals must carefully consider the investor’s financial goals, time horizon, liquidity needs, and risk tolerance when evaluating which share class is appropriate. Recommending the wrong share class can lead to unsuitable investments, resulting in excessive fees or liquidity constraints that are not aligned with the investor’s objectives. A comprehensive suitability analysis must also include an explanation of the cost implications and surrender periods associated with each share class, ensuring that investors are fully informed before committing to a variable annuity.

Given the complexities of variable annuities, investors should exercise caution when considering these contracts. Unfortunately, not all brokers act in their clients’ best interests. Instances of misconduct, such as failing to disclose risks, recommending unsuitable products, or engaging in excessive trading to generate commissions, can lead to significant financial losses. If you suspect that a broker has engaged in misconduct, consulting with a securities attorney is essential. At AMW Law PLLC, we can review your case, identify misconduct, and help you pursue remedies, including recovering lost funds.

Variable annuities can be a valuable tool for retirement planning, but their complexity, high costs, and exposure to market risks require careful consideration. Compared to less costly products such as mutual funds, variable annuities demand a higher level of scrutiny to ensure they align with an investor’s goals and financial circumstances. Potential investors should thoroughly evaluate their financial goals and consult with qualified financial advisors before committing to a variable annuity. If you believe you have been misled or harmed by a broker’s actions, contact AMW Law PLLC for a consultation to protect your financial future.